What To Do About Expensive US Stocks

Let's be honest, US stocks are getting expensive. The earnings yield on US Stocks is about 4% at the moment, that's fairly low relative to history. In fact, even bulls on the US stock market would find it hard to disagree that stocks are looking a little pricey.

There are lots of ways to value stocks, but most metrics put major US indices such as the S&P 500 somewhere between expensive and very expensive. Robert Shiller of Yale recently called the US market "dangerous". Now, we're not at the highs we saw around the tech bubble of 2000, and this market is less reliant on internet mania for momentum, but on a host of metrics it's starting to number among the most expensive US markets in over a century of market history. Saying that the stock market isn't at the most expensive its ever been is not much comfort and certainly doesn't make it cheap. Saying that the bull market may have another few years left, is not the sort of long-term investing we should aspire to.

Now, this isn't supposed to be a rant about imminent market decline. Stocks, especially US stocks, have historically been a good long-term investment, and market crashes get more attention than they deserve. A highly valued stock market is more likely to signal lower returns in future than a stock market crash, since crashes are so hard to predict and valuation doesn't help much in short-term prediction. There are actions it may be prudent to take now, but we'll get to that later.

The Case In Favor Of US Stocks

Let's consider for a moment the arguments in favor of US stocks. The first is simply momentum, a rising market has a tendency to keep rising, all else equal. This implies we shouldn't worry too much about the US market, until it starts to decline. That may sound obvious, but there is substantial research behind that idea (called momentum). So we should be wary, but perhaps its too early to worry about US stocks right now while the upward march continues, thus far the S&P 500 is up over 7% in 2017.

The other angle is simply that investing is a relative game. I mentioned above that the earnings yield on US stocks is around 4% currently, well that only really matters if you can get, for example, a comparable 5% or better return somewhere else. Currently quality bonds issued by the US government are paying around 1% to 2%, so stocks look attractive when compared with US bonds. None other than the great investor, Warren Buffet has made this argument.

Finally, investing in a country is broadly related to the economic performance of that country and its hard to argue that the US has now come out of the last recession well, with low unemployment and a reasonable and growth-oriented economic climate. Even business spending and housing, which were weaker parts of the US economy appear to have resumed growth. It may not be the level of growth we were hoping for compared to past expansion periods, but the recent US growth track record is better than recent trends in Europe and Japan.

So there are still some arguments to be made in favor of US stocks, but now let's examine the other side of the coin.

...And The Case Against

First off, buying US stocks because they are rising is a risky proposition if many others are doing the same. In his well-researched book, The Myth Of The Rational Market, Justin Fox suggests that the 1987 "Black Monday" crash in which major markets lost 20% or more of their value was in response to broad usage of "portfolio insurance" i.e. selling stocks because they were falling to avoid future losses. Portfolio insurance sounds smart if you're doing it alone. However if a lot of people are doing it, as they apparently were, then you end up with a market crash should the markets already be heading down - far more sellers than buyers. Therefore, I'd sound a note of caution on strategies that call for you to get out of the US markets right before everyone else. Great on paper, risky in practice. Also, even proponents of momentum (buying good performing investments) would argue it can only really forecast out for 12 months or so. Momentum, to the extent it works, only generally helps you for the shorter term.

Then if investing is a relative game, the good news is there are lots of other assets out there. It's not simply a decision between US stocks and US bonds. Markets are global. If the US market is yielding 4%, stock's outside the US yield approximately 5%. And if you can stomach the risk of emerging markets, emerging market funds currently yield 6% in aggregate. These apparently small differences can have a major impact on returns. Over 12 years, a steady 6% return doubles your money, a 4% return grows it 60%. The differences add up. Earnings yield (the inverse of the P/E ratio) isn't the only way to value stocks, but a range of similar valuation indicators whether price to book, dividend yield, price to cashflow or price to sales, are telling a broadly similar story. If you believe that you hold an investment because of the cash it will generate, then this should be a concern to you.

Finally, the US has put in a relatively strong economic performance in recent years, but the stock markets are generally forward looking, and this year Japan and Europe are starting to catch up to US growth on IMF projections, while India and China continue to grow at more than double the US rate. These are forecasts so much could change, but the US may be challenged to economically outperform other developed markets by a significant margin in the coming years in the same way that we saw the US take the lead in growth for major developed markets after 2008. In fact, the high rates of unemployment in Europe, suggest there may be room for growth if jobs can expand.

Home Bias

If you have a lot of US stocks in your portfolio, you're not alone, research by Fidelity, suggests that their US client portfolios tend to have over 80% exposure to the US market. This is extremely high, consider that the US makes up about a quarter of the global economy and half the global stock market. So those numbers would lead you to 25% or 50% exposure in a portfolio. Those values make it hard to see how you get to 80%. But it's not just Americans who like holding stocks in their own country - surveys have found similar trends in the UK and Japan, for example Japanese investors like to hold Japanese stocks, but it's not ideal from a diversification standpoint. People like to own stocks they are familiar with, but that isn't the best way to build a portfolio, it may lead to taking on too much risk.

Diversification

So there are signs that the US market may be expensive and indications that other markets internationally may offer better value. What should you do? Well, it turns out that even if you had full confidence in US stock valuations, 80% exposure to US stocks may still be too high. Diversification is basically a free lunch in investing, and investing doesn't offer many free lunches. Diversification means that if you combine assets that behave differently, yet still have a positive return you can create a portfolio that offers a smoother return. That most investors have 80% in US stocks suggests the logic of diversification still isn't being followed.

Buying international stocks used to be challenging, now it's pretty easy. If you want to get exposure to foreign stocks in developed countries, Vanguard has a Exchange Traded Fund, the Vanguard FTSE Developed Markets ETF (ticker: VEA) that holds over 3,000 stocks with significant exposure to 13 countries such as Japan, France and Australia and smaller holding in many others. This can help diversification as these countries have different industries, different currency exposures and different political and economic cycles compared to the US.

That's not to say that US is better or worse, but simply that including different countries in your portfolio avoids having all your eggs in one basket. VEA offers you at least 13 different baskets. I've suggested the Vanguard fund here as Vanguard has a strong investor-centric philosophy, a robust track record, significant assets in the ETF, plus the expense ratio is 0.07% a year, which is pretty low. Generally, looking for funds with lower costs is a good idea. iShares and Charles Schwab also currently offer competitively priced ETFs for many regions if you don't want to use Vanguard, or if you're more sophisticated you could purchase a broad range of international stocks directly.

And, as I mentioned previously, taken diversification a step further, you can include emerging markets. Emerging markets can involve more risks in terms of political issues and currency volatility, but the high growth rates we've seen in India and China recently are hard to ignore. Furthermore, emerging markets appear relatively inexpensive compared to other stock markets. Again, maintaining a portfolio of foreign stocks can be fairly complex, but here again Exchange Traded Funds (ETFs) can be a good route to get there as a one stop shop. The Vanguard FTSE Emerging Markets ETF (ticker: VWO) has material exposure to 10 countries such as China, India and Thailand and smaller exposure to many others. Fees are slightly higher at 0.14% compared to the developed market fund above, but once again it provides a robust way to smooth your returns as you add different countries into your portfolio. Again, Charles Schwab and iShares give you low cost alternatives, but Vanguard's offering has more than 10 times the assets of those funds, which can help trading liquidity and mean potentially lower spreads when you trade the shares.

Currency

It's hard to discuss international investing without talking about how currencies can impact your investment returns. Generally, foreign stocks do well when the dollar weakens and poorly as it rises. It's not the sole factor, but it is a major consideration. We've now seen the dollar broadly rise for 6 years since 2011, with a particularly strong run in late 2014. It's possible things here are changing as the dollar's direction in recent months have been less obvious.

Again though the goal here is to build a better portfolio from a risk management standpoint, by including a range of diverse stocks, if foreign stocks do better for a period than the US, given currency or valuation trends then that's a bonus. History suggests there are times when the US will lead and times when foreign stocks will lead. The challenge is we've seen such a strong showing for the US markets for the past several years that the benefits of international diversification have been less apparent to those who have short memories or are newer to investing.

However, so far this year, with the US market up 7% and the foreign developed markets (excluding the US) and emerging markets both up around 14% it's possible the tide could be turning. Either way the 80% allocation to US stocks that seems typical of US investors is a lot higher than theory would suggest and using ETFs to get to a more internationally diversified portfolio may make sense. If you're holding a lot of US stocks, considering increasing your international exposure may be a smart move.

Simon is author of Digital Wealth and CIO at Moola. @simonwmoore on Twitter. Articles are educational only, not intended as investment advice.

I am Chief Investment Officer at Moola, and author of Digital Wealth (2015) and Strategic Project Portfolio Management (2009). I am a Chartered Financial Analyst charterholder with an economics degree from Oxford University and an MBA from Northwestern University’s Kellogg s...